Inflation targeting: a view from the ECB

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Inflation targeting is one of those strategies. Following the pioneering approach of the Reserve Bank of New Zealand in the early 1990s, a large number of central banks have formally adopted an "inflation targeting framework"; and today we can count around 20 central banks that refer to this approach. At the same time the inflation-targeting framework has triggered a large amount of interesting and stimulating theoretical work, as indeed this conference testifies. (5) Looking back at the experience of those central banks, there is no doubt that it has been a success. This is particularly evident in the case of countries starting from high levels of inflation. These countries needed to implement a disinflationary process, where inflation targeting served to guide inflation expectations and provide an explicit framework and direction to monetary policy. The approach has also turned out to be successful in countries with lower inflation, as, for example, the positive experience of the United Kingdom, Sweden, and Canada shows. In the few cases--limited to some emerging economies--where the experience has been somewhat less successful, it is quite evident that problems originated in other areas--notably, often stemming from misguided fiscal policies. (6)

At the same time, while not adopting an inflation-targeting approach, some major central banks have also achieved and maintained price stability, proving that visible success in the management of monetary policy is not confined to inflation-targeting central banks.

In the rest of this paper I will try to substantiate this claim.

3. INFLATION TARGETING

There is a vast amount of literature on inflation targeting, and the first challenge to some readers' eyes is to decide upon a proper definition. Different authors have proposed different, and in some cases conflicting, definitions. (7)

The first and broadest definition of inflation targeting is simply a monetary policy framework that accords overriding importance to the maintenance of price stability, typically defined as a low and stable rate of consumer price inflation. (8) As pointed out in the previous section, given the broad consensus that price stability is the appropriate goal of monetary policy, the strategies pursued by most central banks, including the ECB, would fall under this loose definition. However, this definition suffers from two interrelated weaknesses. First, from the policymaking perspective, it offers no practical guidance for the conduct of monetary policy beyond identifying the primary objective. As such, its practical relevance is rather limited. Second, from a scientific perspective, the definition imposes few empirically testable restrictions on the implementation of monetary policy. As such, it does not allow inflation-targeting strategies to be distinguished from other stability-oriented strategies and their relative merits to be evaluated. Central banks that have pursued strategies other than inflation targeting cannot be meaningfully distinguished on the basis of this definition. For example, Deutsche Bundesbank has been classified as an inflation-targeting central bank by some, despite its long adherence to an intermediate monetary targeting strategy. To put it more provocatively, by this definition all "successful" central banks are inflation targeters, while all "unsuccessful" central banks are not.

Given the problems associated with this broad definition, in the remainder of this paper I will focus on alternative, more restrictive definitions of inflation targeting. Consistent with the existing academic literature on monetary policy, such narrower definitions are typically expressed in terms of a monetary policy framework based on the adoption of a monetary policy rule in which forecasts of future inflation play a central role, either in the form of the so-called instrument rules or of target rules.

An instrument rule expresses the monetary policy instrument--usually a short-term nominal interest rate--as a simple and usually linear function of deviation of a few key macroeconomic variables, generally inflation and the output gap, from their target levels. Usually the literature distinguishes between an outcome-based rule (if the instrument is a function of currently observable variables, as in Taylor, 1993) and a forecast-based rule (if the instrument is an explicit function of the current forecast for key variables in the future).

Under a target rule, the appropriate setting for the monetary policy instrument is defined implicitly as the solution to an optimization problem facing the central bank. This optimization problem is defined by two elements: first, an explicit loss function describing the costs associated with deviations of specific goal variable(s) from their target levels; and, second, a structural model of the economy. Minimization of the loss function subject to the constraints imposed by the economy's structure (as captured by the model) implicitly defines a model-specific optimal interest rate reaction function, which determines the interest rate as a function of all relevant state variables. In this context, an inflation-targeting framework is characterized by the adoption of a loss function that focuses on the deviations of forecast inflation from a target level. (9)

There is a natural complementarity between instrument and target rule characterizations of inflation targeting. A target rule implicitly defines an instrument rule--albeit typically one that is complex and therefore difficult to use in presenting policy decisions to the public. Similarly, it is usually possible to derive a loss function and an economic model that would broadly support a specific instrument rule as the solution to an optimization problem facing the central bank.

Here, I do not want to enter the vast debate on the different definitions of and the choice between instrument and target rules. (10) Nor will I address many of the problematic issues identified by the literature and associated with the adoption of those rules, such as the indeterminacy of equilibria, the issue of commitment to the rules, and the important aspect concerning the measurement of key variables, for example, the output gap. (11) Instead what I wish to discuss here are two more practical pitfalls associated with the narrower definition of inflation targeting, namely, the central role of macroeconomic forecasts in inflation targeting, on the one hand, and the robustness of the rules in view of the possible presence of model misspecifications, on the other.

Information Content and Forecasts

As pointed out above, simple outcome-based instrument rules constrain the central bank to respond only to developments in observed inflation and the output gap, and thus not to make use of other available evidence about the state of the economy. However, it is widely recognized that an efficient monetary policy should exploit all relevant information. By imposing an arbitrary partition on the data, simple instrument rules do not adopt such a full-information approach. This raises the issue of whether those rules can be incentive-compatible. If a central bank is aware of information suggesting that the interest rate implied by the rule might be inappropriate (e.g., because of weakness in the financial system), it would have an incentive to deviate from the rule. Given the incentive for such deviations, it is questionable whether central banks would follow such a rule and thus whether the ex ante commitment to this rule can be credible. However, if the rule lacked credibility, it is unlikely to help stabilize private inflation and interest rate expectations.

Forecast-based rules partially overcome the information restrictions imposed by outcome-based Taylor-like rules, making the instrument respond to expectations of future inflation and the output gap. To quote Haldane and Batini (1998): "expected inflation ought to embody all information contained within the myriad indicators that affect the future path of inflation." Along the same lines, Clarida, Gali, and Gertler (2000) characterize forecast-based rules as making use of "a broad array of information (beyond lagged inflation and output) to form beliefs about the future condition of the economy, a feature that we find highly realistic."

However, this opens the door to the problem of the complexity of the construction and nature of the forecast. For example, which is the proper model to forecast? What is the proper way of treating the central bank's monetary policy responses in the future projection or of using market participants' forecasts? (12) Instead of tackling these issues, let me focus on another main critique by challenging the view that forecasts, particularly inflation forecasts, are sufficient statistics on the state of the economy and for monetary policy.

Source: Findarticles.com

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